It is very easy to feel complacent at this time, as Western economies seem to be past the worst, and equity markets are soaring to new highs each day. What could possibly go wrong and cause another downturn? Surely a downturn would be relatively mild anyway, just a brief pause en route to a sustained, long-term period of global growth?

Allow me to present a different view.

Are you aware of the threat of deflation? How about we call it the reality of deflation to be more accurate. The source of this deflation is not the Western world, but increasingly we are noticing its impact.

The problem is China, and other parts of the developing world, which have issued huge levels of debt since the 2008-09 crisis, aided by artificially low interest rates and hot money from the West. Much of this Chinese debt has been issued by government entities, with no profit incentive, just a vague aim to make life better for the citizens of China. The problem with this debt (and of course with all debt) is that it carries an interest charge which someone has to pay, and it inevitably leads to massive oversupply. Here are a few items of data regarding China’s debt levels:

In a long-awaited report, China’s National Audit Office said local government debts had increased almost 70 per cent to reach Rmb17.9tn ($2.95tn) by the end of June. The NAO, whose last survey put the burden at Rmb10.7tn at the end of 2010, added that government debt levels were generally “under control” but identified “potential risks in some places”.

The China Banking Regulatory Commission said non-performing loans (NPLs) made by Chinese lenders reached Rb592bn (£58.3bn) in the final three months of last year. The last time NPLs were at the same level was September 2008. Loans by Chinese lenders have grown at an unprecedented rate in the past five years, with banks increasing the size of their balance sheets by Rb89 trillion, an amount roughly equivalent to the size of the entire US banking industry.

Borrowing by Chinese property developers has caused a surge in high-yield bond issues in the last 18 months, according to Moody’s, with more than half of the country’s corporate and project infrastructure debt rated at ‘speculative grade’. Hong Kong’s financial regulator has also warned about the increased use of foreign-currency borrowing to fund China’s continued growth with the stock of non-domestic currency loans, mainly US dollar-denominated, estimated to now be in excess of $1 trillion (£601bn).

Growth in Chinese company debt has been unprecedented. A Thomson Reuters analysis of 945 listed medium and large non-financial firms showed total debt soared by more than 260 percent, from 1.82 trillion yuan ($298.4 billion) to 4.74 trillion yuan ($777.3 billion), between December 2008 and September 2013.

We all saw the impact of risky loans during the credit crisis in 2008, yet the world’s investors appear willing to ignore the risks in China, trusting perhaps that the mighty Chinese government has a plan to tweak things a little here and there to avoid a bursting credit bubble. I seem to recall investors also believed Chairman Bernanke when he claimed there was no housing bubble, and no risk of a nationwide collapse in house prices in America. Trust your eyes, not their lying mouths.

The debt bubble is already starting to burst in China, and investors need to be very wary in our opinion. Here are a few results of the bubble bursting:

Iron ore slipped below $100 a ton for the first time in almost two years on speculation a home-price growth slowdown in China, the biggest user, will dampen demand and worsen the global seaborne glut.Ore with 62 percent content delivered to the Chinese port of Tianjin fell 2.2 percent to $98.50 a dry ton today, the lowest since Sept. 13, 2012, according to data from The Steel Index Ltd. The commodity dropped 27 percent this year, after falling 7.4 percent last year.

The global seaborne surplus will jump from 14 million tons last year to 77 million tons in 2014 and 145 million tons in 2015 as exports from Australia and Brazil increase, according to Goldman Sachs.

Authorities hope to reverse a downturn that has led to a 9.9% nationwide drop in housing sales by value in the first four months of the year, compared with a year earlier. Construction starts for housing have fallen 24.5% over the same period.Property investment directly contributes 12% to the country’s gross domestic product, analysts said. The total is more than 20% if items such as wages paid to construction workers and output from related industries are included.Some property developers have expressed concerns about the market. Earlier this week, Chinese media quoted property tycoon Pan Shiyi’s remarks at a forum, where he compared the nation’s property market to the Titanic. Mr. Pan, chairman of Beijing’s Soho China Ltd. said on his Weibo social-media account that he wasn’t aware reporters were present.

Supply will outpace demand by 316,000 metric tons in 2016, compared with 483,000 tons in 2015, according to the London-based The Rubber Economist. The adviser increased its forecast for this year’s glut by 78 percent in March as output in Thailand, the largest grower and exporter, surpassed predictions. The International Rubber Study Group also raised its estimate saying production will increase as trees planted between 2006 and 2008 mature.

China’s 21st Century Business Herald reports (via MNI):

China Beijing Safe Bank Investment Funds is unable to repay investors on a CNY600 million product

Was due back in March

Officials are now saying they are still unable to pay out, despite the three month extension

The company has around CNY4 billion in outstanding products, with 2,000 investor; most are set to mature in June

The company’s former legal representative has said the company is working on disposing of its assets but can’t guarantee how much investors will get back.

You may be thinking: so what? You may view deflation as helpful to the global economy, with falling prices providing some welcome relief to squeezed households. You would be correct that consumers would welcome some lower prices, but sadly they will also suffer other consequences as investment projects around the globe fail to due falling prices, with property being the most obvious asset class to suffer. Unemployment will rise, debts will default, companies will go bust, demand will begin to fall, banks will become insolvent. All of the inevitable results of a busting debt bubble, with contagion spreading like wildfire across the world.

The coming downturn will be at least as bad as that of 2008/09, probably worse, as we have the ECB gearing up to clean up the banks in Europe in the midst of the worst of it. I wonder if you have any idea of European banks’ debt exposure to the developing world? Hundreds of billions, with no chance of plugging the holes on their balance sheets as assets become worthless. Large depositors in European banks really need our urgent assistance now, the intelligent will save themselves, the unaware will be wiped out. Such is the nature of evolution.

So, some food for thought perhaps? How confident are you that a repeat of 2008-09 doesn’t lie ahead? Is everyone sat with their finger on the ‘sell’ button I wonder? Would you like to hold the ultimate hedge against this outcome? Contact us.

The deflation crisis the world faces will be met with the most elegant of solutions, one that virtually nobody will see coming, and why would they, when they were unable to see the crisis as it loomed in the first place.

“If I had an hour to solve a problem and my life depended on it, I would use the first 55 minutes determining the proper question to ask, for once I knew the proper question, I could solve the problem in less than five minutes.”

– Albert Einstein

Many economists, investors, and politicians are seeking an answer to the question ‘Why is there is so much inequality in the world’, and looking at huge amounts of data over the past century in an attempt to come up with an answer. They will never find their answer, as they are asking the wrong question. The question they should ask is ‘Why did monetary inflation begin rapidly increasing in the world c.100 years ago’.

Monetary inflation benefits those that own assets, and hinders those that need those assets to live their lives. All assets are affected to varying degrees by monetary inflation, as prices reflect the declining value of our currencies.

Do you recognise the magnitude of the world’s problem? The past c.100 years have been an aberration, a period that historians will look back upon with bewilderment. They will ask ‘How on earth could this situation have been allowed to start, continue, and worsen?’ I expect they will eventually pinpoint the exact cause of the problems, and will reflect that 2016-17 was when the world finally took a decisive step back on the right path again. These matters take time to rectify, given the sensitive geopolitical issues at stake.

Here is a visual representation of the problem of the past c.100 years:

It is clear how different the past century has been to the previous 700 years. The right-hand chart notes the date the Federal Reserve was created in America. Please do not assume this represents the answer to our question, it does not. The US suspension of gold convertibility is a good example of another step in the wrong direction, although our fate was sealed many decades before this step.

Thankfully, the period of rapid monetary inflation will come to end, due to planning and actions since the 1940s, with some significant concrete steps expected within the next 3 years, and the process should be complete by c.2035. Then we should expect to see a world where inequality between nations is reduced. There will still be inequality within our species, as we are all influenced by our genetic make-up, and some are brighter and stronger than others. To deny that is to deny our evolutionary history. I am thankful that some of the brightest amongst us saw the misstep that had been taken c.100 years ago, and were able to plot a course back to a more balanced system.

‘In the calendar year 2013 general government deficit was £92.9 billion or 5.8% of GDP, according to the definition used for comparability across the European Union. This was fourth consecutive fall in the deficit as a percentage of GDP. In the financial year 2012/13 general government deficit (or net borrowing) was £81.8 billion, equivalent to 5.2% of gross domestic product (GDP).’

and

‘General government deficit and debt estimates for the calendar year 2012 were affected by the transfer of the Royal Mail Pension Plan assets. This reduced the deficit by £28.0 billion and had the same impact on the financial year 2012/13. The asset purchase facility transfers from the Bank of England in the calendar year 2013 reduced the deficit by £18.6 billion (for the 2012/13 financial year the reduction was £6.4 billion)..’

and

‘General government gross debt (nominal value) was £1,461 billion or 90.6% of GDP for the calendar year 2013. Since 2002, debt as a percentage of GDP has grown in each calendar year.’

So, without the proceeds of the Royal Mail Pension Plan assets, and the remittance to the Treasury of interest on debt purchased by the Bank of England (with Sterling currency created from thin air), the UK would have run a deficit in 2012/13 of £116,200,000,000. Is that what austerity looks like I wonder?

Total debt stood at £1,461,000,000,000 (£1.461 trillion).

The Bank of England owns around £385,000,000,000 (£385 billion) of this debt in the form of gilts (UK government debt securities). Who owns the rest? Most are owned by the British public, via their pension schemes. Some are also owned by the UK’s banks and building societies, and around a third is owned by overseas investors.

Do we ever expect these debts to be repaid? How could we afford that? At a rate of £50 billion a year, it would take 29 years to repay this sum. Do you think the UK will ever run a budget surplus of £50 billion a year?

So, why not default on the debts, simply write them off by refusing to pay? It wouldn’t be the first time a sovereign nation has defaulted on its national debt. We won’t do that, because politicians realise they would be destroying our pension plans and our banks and insurance companies. It’s simply not an option.

So, the UK will follow the ages-old path of maintaining the nominal payments of interest on its debt, as well as the repayment of the borrowed capital, even as it has to take on more debt, or the Bank of England has to create more currency, simply to keep the appearance of solvency alive. Rest assured, the result (as always) will be ever-increasing pressure on the currency, most easily visible via rising inflation in the years ahead, to levels most would be surprised at today. We’ve had 20 years or so of falling inflation, we should not be surprised that the costs of this debt now have to be paid, not overtly, but via the devaluation of our buying power. Debtors should rejoice, whilst savers should be terrified.

Our journey is on auto-pilot now, but who set the course, and demands that the journey is completed? Your fellow voter, that’s who. There is no appetite for austerity in the UK, only a desire for the gravy train to keep on rolling. If the Bank of England can bail out the nation at zero cost via QE, the good times will surely never end. Well, consensus is that we are already in the midst of a healthy recovery as I type. Yet there is no sign of interest rates rising, no sign of any structural adjustments in the UK economy, just a lot more cheap debt and another housing bubble centred on London. Have you noticed the FTSE 100 has been treading water for the past year?

The good times will end, gradually (then very suddenly) within the next 15 years, in a very nasty and painful way, especially for those expecting a comfortable retirement, having saved and invested for their future.

Pay very close attention to the UK’s debt position and the wishes of the electorate in the next few years. Those that are expecting to be paid in full when they come to spend their pension funds and savings stand to be sorely disappointed that their counter-parties and currency managers have let them down badly.